Question

Use AD-SRAS-LRAS model to analyze how the following shocks will affect economic activity in the US economy in the short and the long run; (Use diagram and properly label it to earn maximum points.)

For each shock:

1. Illustrate changes that will occur using AD-AS graph, in short run and explain why each curve shifts.
2. Determine how the prices and the output will be affected in the short-run.
3. Mark the output gap on the diagram. Is the output gap positive or negative?
4. On the same diagram, illustrate how the economy will adjust in the long run and explain the mechanism.
5. Determine how the prices and output will be affected in the long-run.

The shocks are:

1. India, a primary importer of US goods, imposes a tariff on US imports.

Answer 1

A tariff on US exports imposed by trading partner will decrease US exports, which will reduce US net exports, leading to a fall in aggregate demand. AD curve will shift to left, reducing both price level and real GDP, giving rise to a recessionary (negative output) gap in short run.

In the long run, lower price level will decrease wages and production costs. Firms will increase output, increasing aggregate supply. SRAS shifts rightward, intersecting new AD curve at further lower price level but restoring real GDP to potential GDP level.

In following graph, long-run equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect with long-run equilibrium price level P0 and long-run equilibrium real GDP (potential GDP) Y0. When aggregate demand falls, AD curve will shift leftward from AD0 to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real output Y1, with short run negative output gap of (Y0 - Y1). In the long run, SRAS0 shifts right to SRAS1, intersecting AD1 at point C with further lower price level P2 and restoring real GDP to potential GDP level Y0.